How start-ups can tap cash from ordinary people and give the prospect of huge profits in return... What is crowdfunding and how does it work?

Until recently, financing a business involved asking a few people for big sums of money. Crowdfunding is turning this idea on its head, using the internet to help entrepreneurs talk to thousands – if not millions – of potential funders that each contribute a small amount.

The idea is the latest in funding innovations. It means small business owners that are being turned down by High Street banks now have an opportunity to appeal directly to small investors. Equally, whereas investing in small businesses was previously the domain of the very rich, this new concept means anyone can reap the benefits of investing in fledgling start-ups - whether you want to risk £20,000 or £5.

The sector is not without its challenges. While partial industry regulation has now been established, discussions are ongoing between crowdfunding pioneers and regulators in an attempt to find a balance between protecting investors - many small businesses flop early on - while allowing for the creativity and freedom needed to make ventures a success.

Party time: Community crowdfunding platform Spacehive enables community projects to get up and running

Companies
requiring huge amounts of start-up capital
may continue to be funded in more traditional ways - venture capitalists, for example, are likely to carry on plugging the funding gap.

However, in the immediate term, crowdfunding is poised to alter the
entrepreneurial ecosystem significantly - just like angel investing,
venture capital, and private equity before it.

How does crowdfunding work in practice?

Crowdfunding is a fairly new sector that is still developing. While it is an exciting prospect for many - and gives small businesses access to funding opportunities like never before - it can be a confusing arena for most people because it is presented in such a wide spectrum of ways.

Investments or donations are usually made through online platforms, which then coordinate and administer the fundraising.

Projects will range from those helping to finance community-based projects for no financial return (but a fuzzy, warm feeling inside), to sophisticated portfolio-picking, purely for monetary gain.

You could also opt for something in the middle. Abundance Generation, for example, offer investors the chance to invest in green energy and even allow you to visit your windfarm, but is FCA regulated, has shares on the stock market and offers pension investment options.

Investors
receive their money back with interest. Also called peer-to-peer lending or lend-to-save, it allows for the lending of money while bypassing traditional
banks. Returns are financial, but investors also have the benefit of
having contributed to the success of an idea they believe in.

Where crowdsourced money is lent to the very poor, most often in developing countries, no interest is paid
on the loan and the lender is rewarded by doing social good. This is sometimes referred to as 'microfinance'.

People
invest in an opportunity in exchange for equity. Money is exchanged for
a share in the business, project or venture. As with
other types of shares if it is successful
the value goes up. If not, the value goes down and you could lose your money completely.

Interested in finding out more? Watch this video guide by crowdsourcing company Trillion Fund:

What are the risks for investors and how can you realise a profit?

Let there be no doubt - crowdfunding can be a very risky business.

This is because there is no guarantee investors will receive a return. In fact, because the majority of start-up businesses fail you could end up losing all of your money.

While you may receive a share of a business or project, dividends are
rare and your investment could be diluted if more shares are issued.

You must also take a long-term view to any returns - it can take a while before start-ups begin making the big bucks and investors should not expect instant returns on equity investments. Your stake will only become worth something when the business floats on the stock market, in which case it will have enjoyed many years of success, or if management buy back stakes from investors.

However, most crowdfunds are illiquid, meaning
it can be difficult, or even impossible, to claim back money invested or
have it converted back into cash - an issue to bear in mind if you are thinking of taking the equity route. There is no secondary market to
sell your shares or crowdfunding investment.

Alternatively, lending money through debt crowdfunding - ala peer-to-peer lending - gives the option of regular income. There may also be the prospect of dividend returns and some projects will pledge to return ongoing profits to investors. For example Abundance Generation offers
dividends where you will get payments every six months from the energy
generated by a UK solar or windfarm.

But, in general, more ideas get financial support today than can possibly return capital so investors are advised not to risk more than they can stand to lose.

Unfortunately, where money is changing hands – and especially where it
is all done online – there is a risk of fraud, so investors and donators should take
care to protect themselves.

How is crowdfunding regulated?

Industry regulation, established last year by the FCA, covers two types of crowdfunding - debt-based (or lend-to-save) and investment-based.

Under the new rules, investment-based crowdfunding includes firms that deal in 'non-readily realised securities' - quite a mouthful. In other words, mini-bonds and debentures, as well as equity investments, will all fall under the same umbrella because they are all longish-term investments that can't be easily sold off.

Ultimately, the FCA has decided to regulate a platform depending on the type of product it offers, rather than the risk profile of the business you're investing in. So start-ups, green energy investments and mini-bonds have all been lumped together, causing quite a bit of controversy within the industry.

Donation or rewards-based crowdfunding is not included under the new regulation, nor are community share issues.

Very similar rules apply to investment-based crowdfunding as loan-based - ie the marketing must be fair and not misleading, risks should be highlighted and systems must be in place to separate your money from theirs - and ensure there are adequate capital reserves.

The 14 day cooling off period and access to financial ombudsman also apply.

Aside from systems requirements, there are new rules on who is actually allowed to invest their money in crowdfunding. These include:

retail clients who confirm that they will not invest more than 10 per cent of their net investible assets in these products.

So the onus is really on the investor to ensure they fall into one of the above brackets, rather than the platform.

Investors must to tick a box to confirm they fall into one of the above categories. They must also pass an online appropriateness test to prove they are aware of the risks.

Remember, just because the platform is FCA regulated, this does not mean your money is safe - just like any high-risk investment. But it is protected in the event the crowdfunding company goes bust.

The UK crowdfunding scene has also established its own code of conduct through UK Crowdfunding Association. So it could be a good idea to runs some checks on your platform of choice if it doesn't fall under the regulatory umbrella.

The CFA provides strict
guidelines to vet platforms before giving their seal of approval -
including making sure your money is ringfenced away from the
main finances of the company in case it goes bust, and allowing you a 'cooling off' period in case you change your mind after making a donation/investment.

However, just because a crowdfunding platform is unregulated, it does not necessarily mean it is unsafe. Because companies are operating in fairly untested waters, they sometimes fall outside of official channels regulated by the FCA or CFA.

Equally it could mean they have not signed up to safe practices. Take time to do your research if you are interested in a non-regulated platform.

Investors: Top tips

Spacehive: Crowdfunding helped raise money for a community art project

Crowdfunding canadd an interesting dimension to a diversified portfolio,
especially for sophisticated investors. Groves doles out some extra advice:

Make sure you sufficiently understand the business or project, how and
when you might get a return, whether you will receive an equity share in
the business or a regular dividend or interest payment, and the risks
involved before investing in a crowdfund.

Have you thought about tax breaks? Some
platforms allow you to search for companies signed up to the Seed
Enterprise Investment Scheme (SEIS) or Enterprise Investment Schemes
(EIS) (Read below for more details).

Find out how your money is protected if the business, project or even
the crowdfunding platform collapses – in particular check whether the
business has appropriate cash reserves or even insurance supporting it
if it fails.

Invest in what you know. If you work in IT or the food industry, for
example, you can use your expertise to help make better informed
decisions.

You might want
to consider lending money to a company rather than buying a share, in
which case risks may be lower, as will returns (don't forget
crowdfunding does not necessarily equal start-ups).

Do
your research: Read through forum threads and work out what people are
saying about a business model and ask your own questions.

How to make the most of crowdfunding if you are a business

There are thousands, if not millions,
of people out there vying for start-up capital. Here are some top tips
from the CFA's Julia Groves to help get your idea noticed:

It may seem obvious, but your pitch is key. No-one will want to invest in your idea if it sounds rubbish.

Could crowdfunding impact your firm's future?

Concerns have been raised that firms benefiting from equity crowdfunding could struggle to access funding elsewhere in the future.Simon Clarke, chairman of the British Venture Capital Association, says: ‘Anything that brings in money to new ventures is a good thing. 'However, there can be a problem if a firm has previously received equity funding through a crowdfunding platform.’

Do
the work. Make sure you have carried out in-depth research before you
pitch your idea. Anticipate as many questions as possible, include them
in your pitch, and use plain English not jargon.

People buy into a team or
personality. Try and be as engaging and personable as possible -
crowdfunding came from the creative industry originally, so people do
expect you to have a passion for what you do.

Crowdfunding is a very involved
process (certainly more interactive than dealing with a bank) and unless
you can dedicate the time to respond to questions and speak to
potential investors on an almost daily basis through the forum, don't
bother.

Get your friends
and family on board. Potential investors are less likely to give you
money if your funding arrow is stuck at zero. An initial boost of cash
should help to get the ball rolling. Plus, if even your friends and
family don't want to support your idea, maybe it needs rethinking.

Openness
is key. People will ask you questions - it's all transparent and online
so you need to be ready for an active process. Look out for platforms
that help you to prepare your answers if you're unsure.

At
the end of the process your business should be all the better for it.
Your idea will have been thoroughly examined and picked over by
potential investors - try to see this as a positive process because it
will most likely improve your overall end product.

WHY I DECIDED TO INVEST VIA A CROWDFUND

Robert Epsom, 27, a sustainability consultant living in London, recently starting investing in small businesses via Seedrs, an equity-based crowdfunding platform.

Convert: Robbie Epsom is bullish on crowdfunding opportunities

What made you decide to invest through crowdfunding?I’ve
always been a fan of the show Dragons Den and through my Hargreaves
Landsdown account I regularly invest in stocks. Therefore when
crowdfunding reached the UK it was a no-brainer for me.

What are you hoping to get out of crowdfunding?

I see it as a bit of fun. You don’t
need to put down as much as you normally would on the main stock market
to be able to get a good return and there is no trading fee - only a
small percentage charged on any profits realised. I also hope that as I
start to invest larger sums that I can begin to support some of my
investments by providing feedback on ideas.

Seedrs is a window into the world of
start-ups, it is a platform which exposes new ideas to potential
investors - with each new business you learn something new and there is
that possibility of a great return on my investment further down the
line. For all I know I could put a small amount into the next Facebook
or Google and be a shareholder right from the start – where even the
tiniest of percentage equity can be worth millions!

How do you pick your investments?

Unlike buying actual shares, I tend
to look for the start-ups which are receiving the most attention in
terms of investments (amount of people and size of single investments). I
also review the information provided through Seedrs, the Q&A’s and speed at which they’re being snapped
up (a factor of days since listing and percentage invested).

Unlike Warren Buffet's principle of
‘you pay a very high price in the stock market for a cheery consensus’ –
the same is not the case for start-ups. The price is set for the
percentage equity and the only factors to really consider are 'do you
think the business will succeed?' and 'is it worth the asking price?' In
other words, the price is not influenced by the opinions of optimistic
bullish investors!

Unless an idea is really great I
would always select a SEIS registered start-up over one that isn’t. This
allows me to claim back up to 50 per cent of my original investment off
my income tax. I also have the potential to claim back more if the
start-up fails and it means no capital gains tax if it’s a success. This
is a great way for the government to support start-ups and enterprise
and reduce risk to individual investors, rather than corporate banks.

What is the actual process for picking and putting your money into a business?

The whole idea of crowdfunding is to
spread the risk, essentially creating your own bespoke fund of emerging
businesses.

Whenever I spot a potential
opportunity I monitor it by adding
the start-up to my favourites and keeping an eye on it over a period of
time; some can be listed for a hundred plus days and others can be fully
funded in a matter of days.

When I’m comfortable that I think the
business has a real chance of succeeding and I’ve had time to thoroughly
review the idea I then decide if I’m going to invest. When I’m ready to
invest I decide the amount I’m willing to risk for that specific
start-up and instantly transfer the exact amount into Seedrs.

Reviewing the Q&A section often
helps with any unanswered questions following my review of the video,
text in Seedrs and the start-up's website. I haven’t yet felt the need
(probably as I’ve not started putting down significant sums yet) to
directly interrogate the entrepreneur.

Did you have any reservations?

I would never invest as much into
crowdfunding as I would funds, stocks, bonds or REITs as, due to the
risks attached, it has to be cash that you’re willing to lose.

Seedrs advise that investors only
put in a small portion of their capital due to the high risk; for £0-10k
investors are limited to a maximum aggregated £1,000 investment, 10-20k
a maximum of 2,000 and so on.

Although I am still well aware that
the statistics show that most start-ups fail I feel that with a good
selection process, patience, limiting myself to small investments into a
broad range of start-ups and primarily selecting SEIS/EIS eligible
start-ups then I am offsetting the risk as much as I possibly can.

There is obviously a large a risk
with each start-up that you’ll lose money but that is the nature of
investing; I take comfort in the fact that there is also potential to
make a large amount of money and it will take only a small amount to
succeed to offset a large amount of failures.

Have you made any money yet?

I have received my share certificates
for four of my start-ups. However, as Seedrs was only launched recently I
have not made any money yet. Unlike traditional stocks which will
fluctuate daily and you can sell at any time; with start-ups you have to
wait until the company either floats or the majority owner buys back
the shares from the investors – or for any dividends to be paid out
(however the latter is less common with start-ups). As a result, making
any return on these types of investments is a long-term thing and the
cash is definitely not liquid and can be locked up for years before any
return is realised.

The attitude I have is that it’s like
planting lots of seeds and hopefully every now and again over the next
decade I’ll get a cash bonus here and there as some of the start-ups I
selected grow and make it to a mature business.